Lessons From a Gazillionaire’s Bad Call

Hedge fund manager John Paulson has generated billions from making big calls. His most notable one, of course, was on the implosion of the subprime market back in 2007.

From there, he bet big on a comeback in banks, such as Bank of America (NYSE:BAC[1]) and Citigroup (NYSE:C[2]). He even made a bundle on gold through a massive investment in the SPDR Gold Shares (NYSE:GLD[3]).

However, as of this year, things haven’t gone so well. For example, it looks like Paulson’s flagship fund, Advantage Plus, is down 31% for the year (as of the end of July). Even the unleveraged version was off 22% (however, these numbers certainly are in flux as the markets continue to be extremely volatile).

Granted, Paulson is not alone. It’s been tough for many other hedge funds, especially those that focus on macro strategies — like currencies and interest rates — as well as commodities. According to Hedge Fund Research, the average return for hedge funds is -6.1 for the year.

What went wrong? Basically, Paulson made the bet that there would be more growth in the U.S. and even strength in the housing market.

Well, it’s never easy to predict the global economy — especially in today’s volatile world. In fact, it looks like even Federal Reserve Chairman Ben Bernanke has misjudged the problems in the U.S. The gross domestic product is growing at an anemic 1.3% annual rate, and consumer confidence has plunged to a point not seen since May 1980.

OK, so what is the lesson here for investors? First of all, it is important to always be cautious, especially when there is mounting evidence of a global slowdown. Keep in mind that recessions are horrible for equities and often result in bear markets.

Next, investors should be restrained with stock positions. A stark example is Paulson’s investment in Sino-Forest Corp, which is a large Chinese forestry company. Because of allegations of dubious accounting, he had to take a big loss.

So while Paulson’s bet-the-ranch approach has resulted in substantial results, it can easily mean disaster. And it doesn’t matter if the investor is one of the world’s best.

Tom Taulli’s latest book is “All About Short Selling”[4] and he has an upcoming book called “All About Commodities.”[5] You can find him at Twitter account @ttaulli[6]. He does not own a position in any of the stocks named here.